Monday, May 30, 2011

The hedge fund industry asked the Financial Stability Board to consider the improvements made by hedge fund counterparties to their risk management practices, as well the new regulations adopted since the advent of the financial crisis, as the Board explores regulatory measures for monitoring the shadow banking system and addressing systemic risks posed by shadow banking. In a letter to the Board, the Managed Funds Association said that the activities of hedge funds are unlikely to pose the types of systemic risks or regulatory arbitrage that concerns the Board.

Since the failure of LTCM, noted the letter, there have been significant changes in the market with respect to counterparty risk management. Counterparties now consistently limit the amount of leverage used by hedge funds by requiring the use of collateral to secure financing to hedge funds. Also, as a result of improvements to counterparty risk management best practices, financial institutions today conduct more in-depth due diligence on, and have a much greater degree of transparency with respect to, their hedge fund clients’ overall portfolios. Many of these changes have been brought about by the Counterparty Risk Management Policy Group

In its discussion draft, the Financial Stability Board proposed four approaches for monitoring the shadow banking system. First, the indirect regulation of bank interactions with hedge funds and other shadow banking entities. Second, the direct regulation of hedge funds and other shadow banking entities. Third, the regulation of particular instruments, markets or activities. Fourth, the employment of macro-prudential measures through policies to strengthen market infrastructure.

The MFA believes that the macro-prudential measures approach would be the most proportionate and efficient option since it would allow regulators to monitor the financial system as a whole and manage the systemic risks appropriately. Steps can then be taken at the proper time, when regulators determine that there may be excessive risk to the system as a whole. In this regard, hedge fund managers would provide regulators with relevant information on the funds they manage in order to allow for efficient monitoring, provided that regulators establish appropriate confidentiality protections for sensitive information. Indeed, emphasized the MFA, the Dodd-Frank Act and the EU Alternative Investment Fund Managers Directive already mandate or will mandate such heightened transparency to regulators.

The direct regulation of shadow banking entities would not be appropriate, said the hedge fund group, since such would be inconsistent with the FSB’s proposed definition of “shadow banking system,” which does not identify specific entities but rather points to a collective system. In addition, hedge fund managers and the markets in which they operate are already subject to extensive regulation.

Following the recent enactment of several legislative initiatives, the regulatory supervision of the hedge fund industry has been enhanced in many respects. For example, under the Dodd-Frank Act, hedge fund advisers are required to register with the SEC and are subject to increased regulatory reporting and transparency requirements. In the European Union, hedge fund managers are subject to the AIFM Directive, which requires compulsory authorization and imposes capital, disclosure and reporting obligations. Hong Kong and Singapore (the main locations for hedge fund managers in Asia) have similarly enhanced their regulatory requirements of fund managers.

Similarly, the regulation of particular instruments, markets or activities is not an attractive option. The MFA is concerned that regulation of instruments, markets or activities over and beyond what is already required by the Dodd Frank Act or the EU Markets in Financial Instruments Directive (MiFID) Directive would result in many types of entities being caught in the regulatory net that have nothing to do with the credit intermediation chain. This would result in an excessive regulatory burden placed on the market in a manner which is not proportionate with the perceived risks.

As part of its review, the MFA asked the Board to consider the unique characteristics of hedge funds. Although hedge funds are often characterized as being highly leveraged financial institutions, said the MFA, the fact is that they are significantly less leveraged than other financial market participants. Given the limited leverage and the collateral posted by hedge funds, any losses that hedge funds incur are almost exclusively borne by their investors, not their creditors, counterparties, or the general financial system.

There are generally two sources of funds for a hedge fund, explained the MFA, its investors and its counterparties, typically global banks or broker-dealers. Hedge fund borrowings from counterparties are done almost exclusively on a secured basis, secured by fund assets or posted collateral, which limits the amount of leverage that any fund may obtain. In the United States, Regulations T, U and X with respect to securities, and regulations mandated under the Dodd-Frank Act with respect to derivatives, impose margin or collateral requirements, thereby restricting the amount of credit that a financial institution can extend to counterparties, including hedge funds. Similarly, European proposals with respect to regulation of the derivatives markets also contain provisions that will have the effect of restricting the amount of leverage that can be obtained by derivatives users, including hedge funds

Hedge fund borrowings are thus done almost exclusively on a secured basis. The posting of collateral by hedge funds reduces the credit exposure of counterparty financial institutions to those funds. Consequently, hedge funds are substantially less likely to contribute to systemic risk by causing the failure of a systemically significant counterparty, such as a major bank. Moreover, the MFA noted that hedge funds often diversify their exposures across many counterparties, mitigating the risk that a fund poses to any one counterparty. For example, following the collapse of Lehman Brothers, many large hedge funds increased the number of prime brokers they use, thus reducing their exposure to

While hedge funds may obtain financing on the repo market and use such financing to acquire longer dated assets, conceded the MFA, the significant difference between typical hedge fund repo liabilities and the typical liabilities of structured investment vehicles or mutual funds is that hedge fund liabilities in repo transactions are part of the collateral and margining process. In addition to the overcollateralization by hedge funds that is built into the repo transaction via haircuts or initial margin, observed the MFA, daily mark-to-market margining allows repo buyers to call for additional cash or securities assets from the hedge fund. Thus, if the value of the repo collateral decreases, the repo buyer can make margin calls and the repo seller is required to deliver additional collateral to the repo buyer, thus ensuring that the hedge fund must always have sufficient assets to meet such potential margin calls.